Understanding The Financial Crisis

Understanding The Financial Crisis

By Larry Swedroe

The 10th anniversary of the Great Financial Crisis is the subject of lots of articles and media coverage. As a result, I’ve been getting many questions about what caused that crisis and what, if any, lessons we can take away from it to help prepare for the almost inevitable next one.

I’ll begin with a brief review of the main causes. (Entire books have been written on the subject.) Unfortunately, while the media often focuses on the failure of financial models, the real causes can be found elsewhere.

Origin Story

The origin of the crisis stemmed from the political objective of increasing home ownership, beginning with FDR and including Reagan, Clinton and George W. Bush. This goal was aided by the enactment of the Community Reinvestment Act (CRA) of 1977. The CRA’s intent was noble—to encourage depository institutions to help meet the credit needs of the communities in which they operate and to eliminate “redlining” (not lending to anyone in certain neighborhoods) and discrimination.

Next up was the Housing and Community Development Act of 1992, which established an “affordable housing” loan purchase mandate for Fannie Mae and Freddie Mac. That mandate was to be regulated by HUD. Initially, the 1992 legislation required that 30% or more of Fannie’s and Freddie’s loan purchases be related to “affordable housing” (borrowers who were below normal lending standards). However, HUD was given the power to set future requirements, and HUD persistently increased the mandates, which encouraged “subprime” mortgages.

By 2007, the goal had reached 55%. In other words, more than half the loans originated were “affordable housing” loans. Like many well-intentioned ideas, they failed to anticipate the unintended consequences, especially when taken to an extreme.

In this case, the goals went too far, with required down payments dropping from 20% to 10% to 5%, then 3% and eventually to 0%. And Fannie Mae and Freddie Mac (backed by an implied government guarantee) were operating with very high amounts of leverage while making these now-very-risky loans.

Another related contributing factor was that in 1995, Fannie Mae and Freddie Mac introduced automated underwriting systems, designed to speed up the underwriting process and approve more loans. These systems, which soon set underwriting standards for most of the industry (whether or not the loans were purchased by the government sponsored entities), greatly relaxed the underwriting standards.

Then we had the 1999 repeal of the Glass Steagall Act, which led to the separation of investment banks and commercial banks. On top of that, we had the failure of the bank regulators to address the issue of depository banks moving risky assets and their associated liabilities off-balance sheet via so-called special purpose vehicles. This allowed the banks to remove those amounts from the capital requirements computation, allowing them to take on more risk.

Additional Factors

Following is a short list of the other major issues that added fuel to the fire that was simmering, and without which the crisis could never have become the conflagration it did. It was a total failure of regulators across the system.

A) Appraisals were massively fraudulent, with a total failure of state and local regulators in the mortgage industry to actually do their jobs and prevent those frauds—the problem wasn’t the lack of regulation but the failure of regulators to do what they were paid to do.

B) Financial institutions massively over-leveraged, and regulations favored housing loans for bank capital standards. Because government policies favored housing, bank capital requirements were much lower for mortgages than for other risk assets. Again, it was a failure of regulators—in this case the Federal Reserve, which oversees the banking industry—to do their job, allowing banks to park assets offshore and not hold sufficient capital given the riskiness of those assets.

C) An often-overlooked cause was the conversion of private investment banks to public companies. That changed the nature of risk-taking at the institutions, which were no longer just investing their own personal capital but that of shareholders and lenders as well. That created a potential misalignment of interests. When they were private companies, the leverage of these banks tended to be in the low single digits. However, once they went public, leverage not only jumped into double digits (while much riskier assets were taken on at the same time), but some were leveraging at more than 20 and 30 to 1. Regulators had oversight of these investment banks and could have prevented that increased leverage. Yet they did nothing. The problem was so large, that by 2007, the five top investment banks had more than $4 trillion in debt, roughly 30% of the size of the U.S. economy.

One more part of the story is often overlooked. It’s the “agency problem” (misalignment of interests) created by allowing the ratings agencies (Moody’s, S&P, Fitch) to have the originators of product pay for the ratings instead of the buyers who rely on the ratings.

This isn’t an issue when dealing with municipal bonds or corporations since neither will typically borrow more to invest in projects if their rating is higher than it should be. However, with asset-backed securities, which depend on having high investment-grade ratings (AAA/AA) to be able to find buyers, AAA/AA ratings will allow for more origination.

By providing higher ratings than were justified by the risks, the ratings agencies could collect more fees, and the investment banks would originate more and earn greater profits. And many employees of the ratings agencies ended up working for the investment banks that helped them work “the system.”

Multiple Factors

Summarizing, great incentives existed that played parts in building up to the crisis. Mortgage bankers made money no matter the credit or interest rate risks. They underwrote to the standards set by Fannie and Freddie and VA, which were persistently pushed to make terms looser.

Then, incented by fees to originators, there were massive frauds on appraisals that the regulators failed to even address. Investment banks had incentives to buy and package the junk mortgages and sell them to the public. Rating agencies made more money as they approved what was junk and found ways to call it AAA or AA. And finally, regulators totally failed to do their jobs.

These were the causes of the Great Financial Crisis, not the poorly designed models used by the agencies and banks to justify the positions they were taking. In other words, models are only as good as the assumptions used in them. If you base models on sound financial theory and very long periods of time that demonstrate persistence and pervasiveness of the evidence, you can have some degree of confidence that the models reflect reality, or at least a reasonable approximation. On the other hand, if there is no theory, nor evidence to support the model, it’s worse than worthless, because you are relying on the output to make decisions.

The bottom line is that the poor models would not have mattered if the underlying causes did not exist. They were just enablers, not underlying causes.

A good example of this were models that assumed that real estate never goes down, so “flat” was a “worst case scenario.” One can only assume that those using a model with that type of assumption had never heard of the Great Depression.

Unaddressed Problems

Unfortunately, many of the problems discussed above have not been corrected, which means a repeat is possible, if not likely. While bank capital standards have been raised, we still have banks that are too big to fail.

The solution to that is simple: As banks get larger, require more capital. For example, for each incremental $10 billion of assets, the equity capital requirement could be 1% higher. Eventually, equity capital would be too costly. Another option is to require that bank debt be converted to equity if the bank’s capital ratio falls below a certain level.

These are simple solutions that don’t require regulations that stifle business, innovation and the economy in ways that the Dodd-Frank Act did. For example, since the enactment of that bill, almost no small banks have been started in the U.S. And small banks make most of the loans to small businesses, which in turn create most of the new jobs.

That contributed to the slowest economic recovery the U.S. has experienced, without a single year of 3% growth in GNP in the eight succeeding years. It’s hard to argue that’s a coincidence, because historically, the steeper the recession, the stronger the recovery.

Sadly, nothing in that bill addressed the real issues behind the crisis—certainly not the too-big-to-fail problem, as banks have become much larger as the increased costs of regulation lead to the need for economies of scale and ever larger banks. And we still have the problem of the ratings agencies being paid by originators of asset-backed securities, not the buyers. That should be changed.

Now let’s consider what investors should have learned from that crisis.

Lessons Learned

Here’s my list of 10 important lessons the crisis taught investors.

1. It was a reminder to never treat the unlikely as impossible and that severe bear markets can and do happen. It’s why, when designing your investment policy statement, you need to be sure your allocation to risky assets does not exceed your ability, willingness or need to take risk (see “The Only Guide You’ll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments”). And while we were lucky that stocks began their recovery in March 2009, it’s important to understand that bear markets can last a lot longer. Thus, an investment plan should incorporate the potential for extended bear markets, like the kind Japan experienced after the Nikkei Index peaked at 38,916 on Dec. 29, 1989. It finally reached its low of 7,054 on March 10, 2009. And at about 23,400 (its level on Sept. 18, 2018), it is still down about 40% from its peak almost 29 years later.

2. Overconfidence is an all-too-human trait. Being overconfident about your risk tolerance can be costly, because the easiest person to fool is yourself. Investors who had less risk tolerance than they thought pre-crisis were forced to re-evaluate their willingness to take risk. This may have caused them to engage in panic selling, totally abandoning equities, or at the very least, move to a more conservative allocation during the crisis. Note that correcting a mistake is better than perpetuating it, as there was no guarantee the crisis would end favorably.

3. Global diversification of equity risks won’t help you when you have systemic risks that impact the entire global economy in similar ways. During such times, the correlation of risky assets jumps toward 1. Unfortunately, many investors take the wrong lesson from that, thinking it means they don’t need to include international equities in their portfolio. However, that’s the wrong conclusion. While correlations do tend to rise sharply in crises, they tend to revert to longer-term averages over time. Thus, they provide diversification benefits over the long term. In addition, global diversification also helps when there are “disasters” that are idiosyncratic to one country (such as Japan’s bubble bursting in 1989)—and diversification is a free lunch for helping in those cases.

4. The right lesson is to be sure you have a sufficient amount of safe (not risky) fixed-income assets in your portfolio, an amount sufficient to dampen the risk of the overall portfolio to an acceptable level. And be sure you are not overconfident about your ability and willingness to take risk.

5. Sticking to your well-thought-out plan is critically important during times of market turmoil. Investors who abandoned their plan and lowered, or even eliminated, their equity allocation have had significantly lower returns than those who stuck to their plan.

6. A traditional portfolio whose risk is dominated by market beta—like a 60/40 portfolio—doesn’t have 60% of its risk in stocks, but closer to 90%. That’s because stocks are about four or five times more volatile than an intermediate-term Treasury bond, and why typical 60/40 portfolios can experience severe drawdowns in bear markets.

7. The main role of fixed income in a portfolio should be to dampen the risk of the overall portfolio to an acceptable level. Thus, it’s important that your fixed-income assets don’t introduce equity like risk through the backdoor. In 2008, while five-year Treasuries returned +13.1%, the Bloomberg Barclays US High Yield Bond Index Intermediate returned –25.5%. Even if you stuck to investment-grade corporates, the FTSE US Broad Investment-Grade Corporate Bond Index A 3-7 Years returned –4.8% in 2008. If you took on even more credit risk, Vanguard’s High-Yield Corporate Fund Investor Shares (VWEHX), according to Morningstar data, returned –21.3%.

8. A focus by investors on a cash-flow approach to investing can lead them to consider using dividend-paying stocks or REITs as alternatives to safe bonds. Both of these alternatives have significant equity risk. Morningstar data show that, in 2008, the Vanguard High Dividend Yield ETF (VYM) returned -32.1%, and the Vanguard Real Estate ETF (VNQ) returned -37.1%. Such losses could have caused the overall portfolio loss to exceed an investor’s risk tolerance.

9. A strategy that has historically reduced the risk of those severe drawdowns has been to build a portfolio with lower exposure to equities but higher than market exposure to the small and value stocks that have historically provided higher returns. That’s the strategy discussed in detail in “Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility 2018 edition.” The holding of higher expected returning assets allows you to hold more safe bonds. Along with the increased exposure to the size and value factors (which have historically had low correlation to market beta), the greater exposure to safe bonds allows you to create more of a risk parity strategy, avoiding the concentration risk of more traditional portfolios. And since markets are highly efficient, all risky assets should provide similar risk-adjusted returns.

10. Financial innovation in the form of interval funds has provided investors with additional unique sources of risk and return which they can access—risks that reduce the concentration risk of traditional portfolios and thus reduce drawdown risk. The vehicles that my firm recommends are Stone Ridge Alternative Lending Risk Premium Fund (LENDX), Stone Ridge Reinsurance Risk Premium Interval Fund (SRRIX) and Stone Ridge All Asset Variance Risk Premium Fund (AVRPX). In addition, my firm recommends AQR’s Style Premia Alternative (QSPRX) and Alternative Risk Premia (QRPRX) funds, as they too provide exposure to unique sources of risk and return that provide diversification benefits that reduce drawdown risk. We typically recommend that investors consider allocating 10-25% of their portfolio to these assets. And the more conservative the investor, the more these should be considered for their diversification and tail-hedging properties. These strategies and their benefits are discussed in the aforementioned 2018 edition of “Reducing the Risk of Black Swans.” (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Stone Ridge and AQR funds in constructing client portfolios.)

One of my favorite expressions is that even smart people make mistakes. What differentiates them from fools is that they learn from their mistakes and don’t repeat them. Battles are won in the preparatory stage, not on the battlefield where emotions can lead to mistakes.

Hopefully, the above lessons will help you develop an investment policy statement that will allow you to weather the next crisis with equanimity, to sleep well and to enjoy your life while you adhere to that well-thought-out plan that anticipated a future crisis.

This commentary originally appeared October 1 on

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by myself and other featured authors are their own and may not accurately reflect those of Lifeguard Wealth. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2018, Lifeguard Wealth
As always, if you have any questions please contact Lifeguard Wealth.
Portfolio Pain and the Difficulties of Discipline

Portfolio Pain and the Difficulties of Discipline

By Larry Swedroe

Earlier this week, I discussed why it’s so hard to be a disciplined investor, which generally is a prerequisite for being a successful one. Building on this theme, the “Factor Views” section of J.P. Morgan Asset Management’s third-quarter 2018 review provides another example of why successful investing is simple, but not easy.

Value Investing Has Been Painful

Over the last 10 calendar years, Fama-French data from Dimensional Fund Advisors shows that the value premium in the U.S. was slightly negative, at -0.8%. The value premium (HML, or high minus low) is the annual average return on high book-to-market ratio (value) stocks minus the annual average return on low book-to-market ratio (growth) stocks.

Such long periods of underperformance will test the discipline of even those with a strong belief in the value factor. Compounding this issue is that, as the J.P. Morgan Asset Management report points out, since the beginning of 2017, the value factor has posted losses of nearly 15%.

Furthermore, the second quarter of 2018 was the value factor’s second worst since 1990. The result, the report states, is that “the factor is now mired in the second worst drawdown since 1990 (eclipsed only by the dot-com bubble).” The value premium’s poor performance was not confined to the U.S. The report’s authors also write that “the current drawdown is worse in Europe (-20%) and Japan (-21%) than it is in the U.S. (-17%).”

Importantly, the report’s authors offered this perspective: “In our view, this underscores that we are experiencing a natural sell-off of a factor whose performance is always cyclical.”

All risky assets and factors can go through very long periods of negative performance. You can see evidence of this in the following table, which covers the period 1927 through 2017. It shows the odds (expressed as a percentage) of a negative premium over a given time frame. Data in the table is from the Fama/French Data Library.

Occasional Underperformance Happens

Unfortunately, as I have discussed many times in my books and articles, investors often succumb to recency bias (the tendency to overweight recent events/trends and ignore long-term evidence). This leads investors to buy after periods of strong performance—when valuations are higher and expected returns are now lower—and sell after periods of poor performance—when valuations are lower and expected returns are now higher. Buying high and selling low is not exactly a recipe for success.

The correct way to think about the value factor’s recent underperformance is that, as the authors of the J.P. Morgan Asset Management report point out, “the opportunity set for the value factor continued to improve alongside the sell-off, as is typically the case for a mean-reverting factor such as value.”

They continue: “While value stocks are by definition cheaper than their more expensive counterparts, the gap in valuation is elevated relative to history (79th percentile dating back to 1990), which should point to above-average returns going forward. Historically, when the factor has been this cheap it has delivered average returns of 12% over the next 12 months and been positive 75% of the time. Further, gains in the value factor have tended to occur in batches—in fact, the top 20 months of performance account for 76% of the value factor’s gains since 1990. Given the above-average opportunity set … prospects for the value factor look particularly attractive at this point.”

Of course, this doesn’t guarantee the value factor will outperform in the near—or even the distant—future. However, it does increase the odds of that outperformance occurring. Because there are no clear crystal balls in investing, only cloudy ones, success is about putting the odds in your favor.

Curse Of Daily Liquidity

Two major benefits of owning mutual funds are that they provide daily liquidity and they can be traded at little to no cost. But the ability to sell on a daily basis can also be a curse for investors who lack discipline.

Consider how investors might behave if home prices somehow were computed daily and houses could be traded as easily and as cheaply as stocks. It is certainly possible that home price fluctuations would more closely resemble stock behavior than they do now in the absence of daily liquidity.

For example, imagine you own an investment property on Miami Beach and a major hurricane is poised to strike in the next few days. The price of homes in the area might take a significant hit. Most likely, you are not going to be tempted to sell. Instead, you would wait for the weather to clear. Perhaps investors do better with real estate than with stocks, because they find it more challenging to adopt the buy-and-hold strategy that works well in real estate and apply it to equities.


I hope my recent articles on the need for discipline will help you avoid mistakes associated with recency and resulting (as discussed in this article’s aforementioned companion piece). Ignore the noise of the market and work toward accepting even very long periods of underperformance as the “price” you pay for investing in risky assets in the expectation (but not guarantee) that you will be rewarded with a risk premium.

This commentary originally appeared August 1 on

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by myself and other featured authors are their own and may not accurately reflect those of Lifeguard Wealth. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2018, Lifeguard Wealth
As always, if you have any questions please contact Lifeguard Wealth.
Mutual Fund Benchmark Discrepancies Can Fool Investors

Mutual Fund Benchmark Discrepancies Can Fool Investors

By Larry Swedroe

Evaluating the performance of actively managed mutual funds generally involves comparing a product’s results with some passive benchmark (the SEC requires that funds select a benchmark for comparison purposes) that follows the same investment “style” as the fund’s portfolio (such as the S&P 500 for large-cap stocks, the S&P MidCap 400 for midcap stocks and the S&P SmallCap 600 for small-cap stocks).

This practice can create problems, as funds can choose benchmarks with less exposure than they do to factors that historically have provided premiums (such as market beta, size, value, momentum, profitability and quality). Thus, the benchmarks have lower expected returns.

This misleading practice is important because, as Berk Sensoy’s study, “Performance Evaluation and Self-Designated Benchmark Indexes in the Mutual Fund Industry,” which appeared in the April 2009 issue of the Journal of Financial Economics, shows, “almost one-third of actively managed, diversified U.S. equity mutual funds specify a size and value/growth benchmark index in the fund prospectus that does not match the fund’s actual style.”

Unfortunately, the same research also shows that when allocating capital, individual investors emphasize comparisons relative to the mutual fund’s self-selected benchmark, not its true, risk-adjusted benchmark. It’s clear that fund companies strategically choose a benchmark that will drive fund flows.

Recent Research

Martijn Cremers, Jon Fulkerson and Timothy Riley contribute to the literature on mutual fund performance relative to self-selected benchmarks with their May 2018 study, “Benchmark Discrepancies and Mutual Fund Performance Evaluation.”

They used a holdings-based procedure to determine whether an actively managed fund has a “benchmark discrepancy”; that is, a benchmark other than the prospectus benchmark that better matches a fund’s actual investment strategy.

To accomplish this objective, they identified the benchmark that has the lowest active share with the fund’s holdings. They considered a fund as having a benchmark discrepancy if its benchmark mismatch was at least 60%. Their calculations revealed 26% of funds in their sample had a benchmark discrepancy. The authors’ data covers the period 1991 through 2015.

Following is a summary of their findings:

  • If the prospectus benchmark and risk-adjusted benchmark are different in month t, then the probability they will still be different in month t+12 is 86%.
  • Funds with a benchmark discrepancy tend to be managed more actively, having a higher active share. They also tend to be younger, have fewer assets, and are more expensive. They also tend to be small-cap and midcap funds.
  • Relative to the prospectus benchmark, funds on average underperform by 0.33% per year, which is not statistically distinguishable from zero (t-stat = -1.06). However, funds underperform by 0.78% per year relative to their appropriate benchmark, which is statistically significant (t-stat = -2.87).
  • For funds with a benchmark discrepancy, the prospectus benchmark typically understates the fund’s factor exposures. Thus, the prospectus benchmark is easier to beat than a benchmark with the same factor exposures as the fund.
  • For mismatched funds, the average return of the more appropriate, risk-adjusted benchmark is 1.5% per year (t-stat = 3.20) higher than the prospectus benchmark’s average return.
  • Traditional factors (market beta, size, value and momentum) explain about a third of the average difference in returns between the more appropriate benchmarks and the prospectus benchmarks. Including nontraditional factors along with traditional factors explains about 87% of the average difference in returns. Among nontraditional factors, the Fama-French profitability factor (RMW) has the largest impact.
  • The findings were strongest among large-cap funds with a benchmark discrepancy, with the prospectus benchmark overstating risk-adjusted performance by 2.41% per year (t-stat of 2.10), all of which can be explained by exposure to traditional as well as nontraditional factors. In other words, large-cap funds with a benchmark discrepancy tend to own smaller-cap stocks than their prospectus benchmarks indicate.
  • The benchmark discrepancies have a significant economic impact on performance evaluation as well as capital allocation, as investors generally focus on fund performance relative to the prospectus benchmark when allocating capital, even when a fund has a benchmark discrepancy.

Cremers, Fulkerson and Riley were able to conclude their results “show that a substantial number of funds have a prospectus benchmark that on average is easier to outperform compared to the benchmark implied by their holdings.”

Thus, the authors explain, “investors in general could considerably improve their capital allocations by avoiding funds where the prospectus benchmark is a poor match for the fund’s portfolio. Put another way, investors could improve their capital allocations by focusing on funds where the prospectus benchmark is a good match.”

Today investors have readily available tools, such as the regression analysis tool at Portfolio Visualizer, to enable them to choose the appropriate benchmark when evaluating the performance of an actively managed fund. Such tools also enable investors to determine if the fund actually has generated alpha after adjusting for exposure to common factors.

Constructing Benchmarks From ETFs

The findings in Cremers, Fulkerson and Riley’s study are consistent with those of an October 2016 study, “Investible Benchmarks for Actively Managed Mutual Funds,” that Riley authored alone. While most of the academic literature compares active funds’ returns to risk-adjusted benchmarks using indexes and/or factor regressions, Riley instead used ETFs to build investable benchmarks for actively managed mutual funds. He did so because, while benchmark index returns don’t include implementation costs, ETF returns do; thus, we have a more real-world comparison.

Riley’s benchmarking process did not make assumptions based on a mutual fund’s stated style or benchmark. Rather, he selected the appropriate benchmark based on a fund’s exposure to common factors (market beta, size, value, momentum, investment and profitability) and return history.

He noted: “The benchmarks can be identified in advance, do not require shorting or leverage, and require only annual rebalancing.” Riley also observed that a similar approach has shown that a portfolio of ETFs can be used to replicate the performance of hedge funds. Given that ETFs are relatively new, and that he needed a sufficient number of ETFs to complete the comparison, his study covered the period 2003 through 2014.

Following is a summary of his findings:

  • The ETFs used in the study had an average expense ratio of 0.31% compared to 1.21% for the actively managed mutual funds. The results using index funds would have been very similar, given their average expense ratio was just slightly higher at 0.36%.
  • On average, just four ETFs were needed to create a benchmark, with the majority of the benchmarks consisting of a single ETF. Among benchmarks that held six ETFs, the highest-ranking ETF had an average weight of 51.6%. The next two highest-ranking ETFs had a combined weight of 34.2%, and the last three ETFs had a combined weight of only 14.1%.
  • Benchmarks were effective at replicating the general return pattern and factor exposures of the actively managed mutual funds, with the average correlation between fund daily returns and benchmark daily returns being 0.97, while the average absolute difference in pricing factor exposures (e.g., market beta, size, value) ranged between 0.06 and 0.12.
  • While there was some variation in replication quality, the benchmarks closely tracked their designated fund even in the tails of the distribution. The 10th percentile of correlation was 0.94 and the 90th percentile of tracking error was 0.43%.
  • How well a benchmark replicated a fund was highly predictable.
  • The average actively managed fund underperformed its benchmark (produced a negative alpha versus the benchmark) by 1.03% per year (with a t-stat of 2.81, which indicates statistical significance) after accounting for expenses. The difference in expense ratios explains 90% of the underperformance.
  • The level of underperformance varies depending on investment style. For example, the average large-cap fund had an alpha of -1.54%, while the average midcap fund had an alpha of -0.42%.
  • Only 38.7% of fund-years had a positive alpha.
  • Actively managed mutual funds in the lowest expense ratio decile underperformed by only 0.35% per year, while those with the highest expense ratios underperformed by 1.61% per year.
  • There was a nearly 1:1 ratio between expense ratio and performance. Thus, if an investor must choose actively managed funds (which, unfortunately, is the case in many 401(k) plans), they should choose ones with the lowest costs within the desired risk profile.
  • There was no evidence that past performance provides valuable information. The best and worst performers in a given year had performance that differed by only 0.23% in the next year.

Riley concluded that because the actively managed funds in his sample managed about $2.5 trillion at the end of 2014, underperformance of 1% a year represented an opportunity cost of $25 billion per year for investors selecting active management. That’s the cost of the triumph of hype, hope and marketing over wisdom, experience and the evidence. Even that cost understates the true cost for taxable investors, as it’s often the case that, for such investors, the greatest cost of active management is taxes.


As Cremers, Fulkerson and Riley note in their study: “Risk-adjustment is central to performance evaluation. To facilitate that process, mutual funds are legally required to provide a benchmark to investors in the fund prospectus. Given that funds rarely change their prospectus benchmark and market themselves in a competitive environment to investors that often have limited sophistication, we might expect funds to respond strategically when constructing their portfolios.

While most funds appear to have a risk-appropriate prospectus benchmark, we find that a substantial portion of funds have a prospectus benchmark that understates risk and, consequently, overstates relative performance. Further, we show that funds benefit from that overstatement, as investor flows respond to performance relative to the prospectus benchmark even when a fund has a benchmark discrepancy.”

The annual SPIVA reports—which use appropriate, not prospectus-based, benchmarks—persistently demonstrate that using actively managed funds is a loser’s game, though choosing inappropriate benchmarks can make it seem otherwise.

The research, including Eugene Fama and Kenneth French’s study, “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” which was published in the October 2010 issue of The Journal of Finance, has found that far fewer active managers (about 2%) are able to outperform appropriate risk-adjusted benchmarks than would be expected by chance. That 2% figure is even before considering taxes, which is typically the largest expense for taxable investors. If taxes were taken into account, the figure would be significantly lower. That makes active management a loser’s game—one that is possible to win, but the odds of doing so are so low it is simply not prudent to try.

This commentary originally appeared June 22 on

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by myself and other featured authors are their own and may not accurately reflect those of Lifeguard Wealth. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2018, Lifeguard Wealth
As always, if you have any questions please contact Lifeguard Wealth.
Making Harmony with Money

Making Harmony with Money

By Tad Gray

Dear Erika and Johannes,

There’s a saying that goes, “The cobbler’s children have no shoes.” It means that we parents don’t always share our professional know-how with our own children. But now that you’re on the cusp of your careers, I would be remiss not to provide you with some financial guidance.

Over the years I’ve been proud to watch you two grow to a remarkable level of artistry, and it has reminded me of all the joy I got from making music when I was younger. I’ve loved watching you from the audience just as I’ve loved the opportunities we’ve had to make music as a family. You’ve each demonstrated so much discipline in the pursuit of your craft. And I want you to know that that same discipline is all you need to manage the more practical sides of your artistic careers.

As you know, I stopped pursuing music professionally when I was 23 – not much older than you are now – in favor of focusing on business. While I don’t regret that decision, financial concerns were an important part of it, so I’m sensitive to the challenges you’ll face. And since your mom continued her own musical career, I have remained connected to the economic reality of a musician’s life.

If there’s one thing I’ve learned during my career in finance, it’s that your mindset is one of your most important tools. You know this is true for music, too. Just as our performance improves when we become more aware of our full selves, so does our relationship with money. With the right mindset, we can develop habits that make for better financial outcomes and sustainable artistic careers.

How so? Consider this situation: You’ve just finished an enjoyable, well-paying gig. Your fellow musicians want to grab some dinner before heading home. Someone suggests an expensive restaurant and, before you know it, the bill is way over budget. “Oh well,” you tell yourself. “The gig paid nicely, so why not?”

How can we avoid traps like this, or even turn them to our advantage? This common situation outlines some of the most important aspects of the mental game between you and your money. Luckily, if you internalize the following lessons, you’ll be able to navigate not just tempting dinners, but a host of tricky financial situations.

We live in a consumerist society – I get that. We’re under a lot of pressure to appear successful, and money is one way we try to do that. But remember that the appearance of wealth is just that. Someone you may envy for all the things they have could be miserably in debt. And if that dinner was too expensive for you, it was probably too expensive for others as well. Luckily, by acknowledging your feelings around finances, you can manage your money in the way that benefits you most.

Now that we’ve considered the importance of mindset, we need to know how to apply good money habits.

Let’s begin with budgeting. A budget is just a plan, and you know my “dad quote” on this: “People don’t plan to fail, they fail to plan.” Eye-rolling aside, you already know this to be true. How else could you have become the accomplished musicians you are today? When we plan, we become empowered by holding ourselves accountable.

Let’s look at a budgeting guideline called the 20/50/30 rule, which describes a good way to allocate income.

To get started, note that you should always pay yourself first. At least 20 percent of your income should be set aside for long-term financial goals, like paying off debt, building an emergency fund or saving for your future.

Then, don’t exceed 50 percent for fixed expenses. These are things that must be paid on time and without fail, including rent, insurance, utilities and more. This leaves the remaining 30 percent for discretionary spending. These are items you have control over: food, clothing, “fun” shopping and so forth.

Now, be mindful of needs versus wants. I may want a new BMW, but my pre-owned Honda fulfills my needs just fine. This applies to many things we spend money on, from clothing to eating out to where we live. We get in trouble when the things we want but can’t afford become fixed expenses in the form of credit card debt, rent or installment payments.

When you’re starting out, these 20/50/30 proportions may not seem achievable. Take them for guidelines until you can get there. After that, beware of “lifestyle creep.” As your career progresses, you might be tempted to use your increased income to upgrade your lifestyle. Instead, reassess those long-term goals. Is your emergency fund where it should be? Are your debt reduction plans on track? If not, fix these first, and stay within the 20/50/30 guidelines.

Building a career in the arts is challenging, and it’s easy to fall prey to negative moods about money. Many feel resigned to their financial struggles and come to believe that they have no influence over their situation. But that’s a toxic outlook for any artist to have. What you do matters – whether it’s making wise spending decisions or creating meaningful work.

I’m certain that musicians today can earn enough money for both a sustainable career and a satisfying life. And just as with music, your journey toward financial well-being is a lifelong one. You’ll make mistakes – we all do – but with the right mindset you don’t have to say, “I’m not good with money.” You can say, “I’m not good yet – and I’m still learning.”

You can do it.


This commentary originally appeared September 6 on

Wealth Advisor Tad Gray, CFP®, penned the following article, an open letter to his children, for, an online, professional resource affiliated with DePauw University that was created to help serious musicians thrive in today’s modern musical landscape. Tad’s daughter, Erika, is a violist and a student at the Curtis Institute of Music. His son, Johannes, is a cellist pursuing an artist diploma at the Barenboim-Said Academy in Berlin.

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